Monday, May 12, 2008

Closing the window, opening the corridor

I strongly recommend reading both the post, and the comment thread regarding the Fed's recent request to begin offering (and taking) interest on bank reserves.
Last week, the Fed decided to ask Congress for the right to pay interest on bank reserves. (Hat tip Barry Ritholtz, see also William Polley, Mark Thoma, Brad DeLong) This is a very big deal.

Don't be misled into thinking that the Fed's proposal is just some arcane, technocratic change. The Federal Reserve is asking taxpayers for a big pile of signed, blank checks. That's far too much power to put in the hands of a quasipublic organization with little democratic accountability. This authority should not be granted without some strong strings attached.
I don't share Steve Waldman's optimism that democratic accountability will help the situation at all. We are talking about a highly technical area in the field of financial regulation, which is probably as arcane as it gets from a policy perspective, and. I cannot fathom how inviting The Mob to the table will help anything.

That said, the ongoing financial crises is making some informal rules formal, and that can only be good (even if, or especially if, the informal rules were bad ones).

1) The Fed will extend essentially FDIC insurance to all deposit holders, not just those keeping their money in commercial banks. The TSLF makes that explicit.

2) The Fed will shift financial losses to tax payers by swapping good collateral for bad collateral. This is more formal than saying they will not shift losses to tax payers by swapping good collateral for bad collateral, and then doing it anyway, but it is not as formal as simply writing out a check to Bear Stearns bond holders, JP Morgan, Lehman Brothers, Goldman Sachs. So I see this as an improvement, but it still has a way to go.

3) The US has the latitude to do what it wants monetarily because of "vendor financing" (great analogy) from PBOC and GCC. Both countries have taken significant amount of their citizen's wealth and given it to Americans. This may actually be the right thing to do since employment is more important than amenities (gotta keep them off the streets!)

4) Risk management in finance is pointless. They key variable ends up being political risk (how big will my bailout be?) Consider this: financials are trading at where they were back in 2000, just coming out of the Internet bubble with 8 record years of profitability in front of them.

5) The Internet bubble gave us Google, Amazon, eBay, Yahoo!, and a whole host of new services and technologies that create real value. What new service or technology that's created real value has come out of the housing bubble, or associated financial bubble of the past 8 years? Does this matter? The US economy seems to need a leading sector -- what will the next one be?

6) The US government will subsidize mortgages, no matter what. $900K homes in California are now underwritten by taxpayers.

7) I expect to see Fannie Mae and Freddie Mac nationalized before all of this is over -- there is an informal arrangement that should certainly be formalized post-haste.


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